Revenue Based Finance

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

Related Content

The Analysis for England and Wales includes articles on Revenue Based Finance – Equity and Revenue Based Finance – Debt

Investment Structure Summary

As for US analysis.  The key distinction between an equity based arrangement and a debt arrangement lies in the circumstances in which the recourse arises, and the liquidation priority of such arrangements. 

A debt arrangement may have some fixed amounts that must be repaid at the end of the term, regardless of whether the revenues have been sufficient to meet the payments.  Certain, specified events of default may crystallize this liability (for example, failure to comply with cash sweep arrangements or insolvency events).  In a liquidation the debt claim would be paid ahead of any distribution to holders of an equity instrument. 

Category

Debt

Category for tax purposes

As a basic matter, the UK tax system treats debt and equity differently.  In broad terms, payments on equity are treated as distributions of profit and therefore not deductible in computing the taxable profit of the issuer. By contrast, finance expense incurred on a debt instrument is generally treated as a cost of earning profit, and therefore taken into account to reduce taxable profit.  Correspondingly, for the holder the return on an equity instrument is usually exempt from tax whilst the return on a debt instrument is usually taxable.

The UK tax code contains rules designed to police the boundary between debt and equity for these purposes.  Pursuant to those rules, loans or debt instruments the return on which varies in line with the performance of the borrower’s business are taxed, in broad terms, as equity instruments rather than debt instruments.

Please see ‘Critical Tax Considerations’ section for the key tax consequences of these rules

Governance Rights

Lenders can negotiate consultation or veto rights in relation to key parts of the business in the credit agreement covenants (entry into, negotiation or termination of key contracts, acquisition and disposal of assets, expansion of the business into new jurisdictions etc). 

Such covenants should fall short of conducting day to day management of the business or execution of the business plan, which is within the purview of the Board as this could risk lenders being categorized as shadow directors. In exceptional circumstances (particularly in a distressed scenario), courts could attribute shadow director status to a lender as a result of significant interference by a lender in the company’s business, but this is a remote risk in the ordinary course where lenders are simply monitoring compliance with covenants. Shadow directorship would carry with it potential liability for any breaches of directors’ duties.  However unlike in many European jurisdictions, there is no concept of equitable subordination in E&W (equitable subordination having the effect that debt claims held by entities exercising control or other shareholder like features would be treated like equity in an insolvency and therefore subordinated to other debt claims). 

Board observer rights are commonly granted in the context of such investments.  

Investor Qualification Requirements

Revenue based lending would not carry with any requirements.  The legislative framework in E&W focusses not on the lender, but on the borrower.  Other than mortgages and consumer credit (including lending money to, or arranging credit for individuals), offering credit to another business is not a regulated activity unless the borrower is:

1. A sole trader

2. A partnership with less than 4 partners

3. An unincorporated association  

Consumer credit activities are regulated by the FCA and key legislation includes the Consumer Credit Act 1974 (CCA) and, since 1 April 2014, the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544) (RAO).

Securitization structures are regulated in E&W.  Accordingly if the revenue based lending might be characterized as a securitization (which looks at whether credit risk in underlying pools of receivables are being re-tranched, then this may be relevant).   A straightforward revue based arrangements (where the revenue is that of the borrower’s), is unlikely to risk such categorization

Currency Considerations

There are no currency limitations on advancing or repaying debt.

Collateral

Yes. 

It is possible to take fixed charges/ mortgages over key assets of the borrower – in particular those linked to revenue such as receivables or bank accounts) as well as a “floating charge” over all or substantially all assets of the borrower.  

Security could be taken on a limited recourse basis – is so that recourse is limited to the assets and the borrower may not be made insolvent. This is common to securitization structures (noting, as set out above, that securitization structures are regulated).

Guarantees may be sought from other members of the borrower group.   

Priority Payment Rights

Debt claims are paid in the order set under under ‘status in insolvency proceedings’ below.  The debt repayment covenants could be contractually structured in the described ways.  Debt claims may also be contractually subordinated to other debt claims by agreement between investors (in intercreditor agreements or priority agreements).  It is common for any debt investor to require that loans made by shareholders to the borrower be contractually subordinated to the repayment of the debt claim.  

Lenders might seek various information rights or other controls over cashflows (eg blocked accounts) to ensure compliance with the repayment covenants and visibility over revenues.  

Distribution and Redemption Limitations

Repayments of interest may be subject to a withholding tax depending on the debt instrument and/ or jurisdiction of the lender.

Legal limitations to pricing or total return

There are no usury laws in effect in the UK.  As set out above certain transactions involving consumer credit are regulated, including in the amount of charges and fees that cab be applied. 

Status in Insolvency Proceedings

In a liquidation scenario, creditors are ranked as follows (with each class of creditors to be paid in full before repayments can be made to the next ranking class): 

• Fixed charge holders
• Administrator’s/ Liquidators’ fees, costs and expenses
• Preferential creditors (unpaid wages/ holiday pay up to a cap, HMRC in respect of certain unpaid taxes)
• Floating charge holders (including prescribed part for unsecured creditors)
• Unsecured creditors (pension schemes, customers, trade creditors, other categories of unpaid taxes)
• Interest incurred on all unsecured debts post-liquidation
• Shareholders

Debt claims (including contingent debt claims) may be compromised under reorganization procedures which apply pre- insolvency. In particular under an English Scheme or Arrangement or Restructuring Plan, implemented pursuant to the Companies Act 2006 claims can be compromised where a certain percentage of creditors in the some ‘class’, or in another ‘class’ have approved a reorganization plan.  Revue linked debt claims (including claims related to future revenue) may be compromised under such plans

Limitation of Liability

Liability mainly rests under the contaminated land regime, the water pollution regime, and the common law of nuisance (Environmental Protection Act 1990 and Environmental Act 1995 – Contaminated land). Liability would lie with those who caused or knowingly permitted the contamination or pollution, and with those responsible for causing or continuing the nuisance. 

This means that the lender’s liability would depend on whether the lender was aware of an environmental risk in the borrower’s business and had sufficient control to influence management of that risk. In particular, lenders may incur liability through exercising financial control or providing funds for an activity that results in contamination; through withholding funds with the result that the borrower was unable to carry out remediation, maintenance works or equipment upgrades, which in turn led to contamination; and where the lender knew (or ought to have known) of the existence or likelihood of the contamination, pollution or nuisance (for example, as a result of information provided by the borrower under information covenants in a facility agreement) and if they had the power and the opportunity to deal with it (for example, by virtue of step-in rights in a security document), but failed to do so

Transfer Restrictions

Private debt can be freely transferred subject to any negotiated contractual restrictions 

Critical Tax Considerations

We have confined our commentary below to the UK tax considerations relevant to the revenue-linked feature of the lending (as opposed to providing commentary on UK tax considerations that arise on lending transactions generally).

The main UK tax considerations include:

1. Non-deductibility for UK corporation tax purposes for corporate borrowers:
   1. Distribution treatment. In general, any amounts paid on securities where the consideration given by the issuer depends to any extent on the results of the issuer’s business is not deductible when calculating a company’s profits subject to UK corporation tax.  There are exceptions to this rule, including where the results dependency is an inverse ratchet or where the payee is subject to UK corporation tax on the return on the debt security.  
   2. Transfer pricing and thin capitalisation rules. To the extent that the results dependency of the return to the holder suggests that the debt fulfils an equity-like function and so the amount invested is not an amount that would at arm’s length have been loaned to the company (i.e., the company is thinly capitalised), it may be that a deduction is denied on that basis under the UK’s transfer pricing rules.
   3. Anti-hybrid rules The UK’s hybrid mismatch rules target certain arrangements that give rise to tax mismatches, typically on cross border transactions.  To the extent that the return on a results dependent loan is characterised as equity in the lender jurisdiction and therefore not subject to tax, that may give rise to a denial of a deduction for the  borrower in the UK. 
2. De-grouping charges:

The revenue-based feature of the loan may cause the borrower to be excluded from a UK tax of which the borrower would otherwise form part, which can in turn lead to de-grouping charges (for example, in circumstances where real estate or other assets have been transferred between group members on a tax neutral basis before the results dependent loan is put in place)

3. Stamp duty considerations:

Loan capital is generally exempt from UK stamp duty but there are certain exceptions to this exemption, including where the loan capital carries a return related to profits (that is not an inverse ratchet). 

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

Related Content

The Analysis for England and Wales includes articles on Revenue Based Finance – Equity and Revenue Based Finance – Debt

Investment Structure Summary

The regime for equity financing in England and Wales (“E&W”) is a flexible one where the shareholders may decide the rights and obligations adhering to shares in the articles of association or even in a separate shareholders’ agreement. 

A company is able to have different classes of shares with different rights attached to them. In this case the investor could benefit from holding preference shares that would guarantee a distribution on a revenue basis (as would need to be set out in the articles of association). 

In relation to a liquidation, shareholders shall only be paid after all creditors and debts have been satisfied. This would mean that a company that does not have enough assets to satisfy creditors would then not be able to pay its shareholders. If the shareholder holds preference shares, then the amount due in relation to these would be paid in priority to the ordinary shareholders.

Category

Debt

Category for tax purposes

As a basic matter, the UK tax system treats debt and equity differently.  In broad terms, payments on equity are treated as distributions of profit and therefore not deductible in computing the taxable profit of the issuer. By contrast, finance expense incurred on a debt instrument is generally treated as a cost of earning profit, and therefore taken into account to reduce taxable profit.  Correspondingly, for the holder the return on an equity instrument is usually exempt from tax whilst the return on a debt instrument is usually taxable.

The UK tax code contains rules designed to police the boundary between debt and equity for these purposes.  Pursuant to those rules, loans or debt instruments the return on which varies in line with the performance of the borrower’s business are taxed, in broad terms, as equity instruments rather than debt instruments.

Please see ‘Critical Tax Considerations’ section for the key tax consequences of these rules.

Governance Rights

Governance rights under the law of E&W are flexible and dictated by what is set out in the articles of association or a shareholders’ agreement (if there is one). Investors may be granted any one or more of the rights referred to). However we would not expect revenue based lending to carry with it any particular governance arrangements/ rights.  

Any upside or equity linked rights that are linked to the investment (such as warrants) would carry the same governance rights as attaching to the equity once crystalized, and may also benefit from shareholder – like consent rights in particular to protect against dilution. 

Investor Qualification Requirements

A shareholder can be based anywhere in the world, they do not need to live in the UK. Foreign controlled companies or owners are treated the same as UK-owned businesses and individuals for the purposes of investment (subject to competition law and regulatory approval for large UK entities and government controlled industries such as transport and energy).

Currency Considerations

Shares in a limited company may be denominated in any currency, and different classes of shares may be denominated in different currencies. 

Collateral

Whilst an equity investment may have the right to receive distributions and payments ahead of other shareholders (in particular preference shares) such an investment is not typically secured as no debt claim arises.  Collateral can be granted as security for performance obligations as well as debt obligations so it is feasible for an agreement to turn over revenue to be secured in a an asset, but that is certainly not typical.   

Priority Payment Rights

As noted above an investment may be made by way of preference shares, with the rights of the preference shareholder  rights set out in the borrower’s articles of association. The preference shares’ rights could be paid at a fixed rate if the directors deem there are profits available for distribution. 

The articles of association or the relevant shareholders’ agreement may include a liquidation preference. The aim of the liquidation preference is allowing the investor to recover the invested amount (or a multiple of the invested amount) with priority over the rest of the shareholders. However this preferred return will still be subordinated to debt claims. 

Distribution and Redemption Limitations

Conditions relating to distributions will be set out in the articles of association and in any case may only be made out of profits for the purpose as verified in the relevant company accounts. 

The relevant company accounts are either: (i) the last annual accounts, (ii) interim accounts or (iii) if the company is declaring a distribution during its first accounting reference period then the distribution shall be made in reference to its initial accounts. 

There are no restrictions on timing of distributions as these can be paid by decision of the board of directors.  

Legal limitations to pricing or total return

N/A

Status in Insolvency Proceedings

In a winding-up scenario, the company’s debts owing to its creditors (preferential, secured and unsecured) must be settled first and then the shareholders of preference shares shall be paid in accordance with the articles of association or shareholders’ agreement. 

Limitation of Liability

If the company that the shareholder invests in is a limited liability company then the shareholder’s liability is limited to its committed investment. 

That means they are only responsible for company debts up to the value of any shares, (assuming no personal guarantees have been signed).

An investor may be considered a shadow director if it, not being formally appointed a director, directly has authority over how the company is run. 

Transfer Restrictions

Transfer restrictions will be dependent on the type of company that is being invested in and the articles of association in force. If the company is a private limited company, there are few restrictions in place

Critical Tax Considerations

We have confined our commentary below to the UK tax considerations relevant to the revenue-linked feature of the lending (as opposed to providing commentary on UK tax considerations that arise on lending transactions generally).

The main UK tax considerations include:

1. Non-deductibility for UK corporation tax purposes for corporate borrowers:
   1. Distribution treatment. In general, any amounts paid on securities where the consideration given by the issuer depends to any extent on the results of the issuer’s business is not deductible when calculating a company’s profits subject to UK corporation tax.  There are exceptions to this rule, including where the results dependency is an inverse ratchet or where the payee is subject to UK corporation tax on the return on the debt security.  
   2. Transfer pricing and thin capitalisation rules. To the extent that the results dependency of the return to the holder suggests that the debt fulfils an equity-like function and so the amount invested is not an amount that would at arm’s length have been loaned to the company (i.e., the company is thinly capitalised), it may be that a deduction is denied on that basis under the UK’s transfer pricing rules.
   3. Anti-hybrid rules The UK’s hybrid mismatch rules target certain arrangements that give rise to tax mismatches, typically on cross border transactions.  To the extent that the return on a results dependent loan is characterised as equity in the lender jurisdiction and therefore not subject to tax, that may give rise to a denial of a deduction for the  borrower in the UK. 
2. De-grouping charges:

The revenue-based feature of the loan may cause the borrower to be excluded from a UK tax of which the borrower would otherwise form part, which can in turn lead to de-grouping charges (for example, in circumstances where real estate or other assets have been transferred between group members on a tax neutral basis before the results dependent loan is put in place)

3. Stamp duty considerations:

Loan capital is generally exempt from UK stamp duty but there are certain exceptions to this exemption, including where the loan capital carries a return related to profits (that is not an inverse ratchet).  

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

This analysis was provided by White & Case SA and Citibank N.A., South Africa Branch

Related Content

The Analysis for South Africa includes articles on Revenue Based Finance – Loans, and Revenue Based Finance – Preference Shares

Executive Summary

The revenue-based finance structures that have been discussed are the common structures that we see in the South African market, namely, revenue participating loans and participating preference share funding. These structures are similar in principle as both structures aim to allow investors to be able to also finance companies and startup business in a way that allows these companies to be able to build their business. Most investors believe that small and medium-sized enterprises and startup businesses have a fair amount of risk as not all start-up business will be successful. These structures are designed to give investors a share in the performance of the business. 

Revenue Participating Loan

Investment Structure Summary

This investment structure involves a loan made by an investor to a business and instead of the investor receiving interest back on the loan, the return on the investment is calculated as a contractually agreed percentage of revenue or a contractually agreed percentage of profit.

Advantages of loans of this nature is that (a) because the return is not calculated with reference to a rate of interest, it is treated as a tax exempt dividend under section 8FA of the Income Tax Act, 1962 (“Income Tax Act”), and (b) the loan can be secured by taking security from the borrower and third parties. However, if security is taken from a third-party then the benefits of the tax-exempt dividend fall away. 

The governance rights are contractual as opposed to a share-based structure where the governance rights can be and generally are built in to the investee company’s constitutional documents 

Category

Revenue participating loans are classified as both debt and equity. These loans have an element of debt because they can be secured and equity because the return on the loans is in the form of an agreed percentage of revenue or an agreed percentage of profit and not linked to a rate of interest, and as such, the investor receives dividend returns. Subject to the loan not being secured by a third-party, the investor will receive a dividend return that is also tax-exempt.

Category for tax purposes

It is a hybrid debt instrument. 

Interest received is treated under section 8FA of the Income Tax Act as a dividend. Section 8FA (2) of the Income Tax Act provides that any amount of interest incurred by an investor in respect of interest on or after the date that the interest becomes “hybrid interest” is (i) deemed to be a dividend in specie in respect of a share that is declared and paid by that company to the person to whom that amount accrued on the last day of the year of assessment of that company during which it is incurred, and (ii) is not deductible. 

The definition of hybrid interest means any interest where the amount of that interest is not determined with reference to a specified rate of interest or not determined with reference to the time value of money

Governance Rights

Governance rights are generally in the form of negative undertakings and are purely contractual where the instrument is constructed as a loan. It is also possible to construct the instrument as a debt security under the Companies Act, 2008 (“Companies Act”) and therefore to include in the terms of the security certain governance rights that are built into the constitutional documents of the borrower.

These are typically constructed as a loan rather than debt security although it is technically possible to structure this investment as a debt security

Investor Qualification Requirements

There are no statutory limitations on an investor to make these loans other than that investor receiving exchange control approval, and registration as a credit provider in accordance with the National Credit Act, 2005 (“NCA”), to the extent applicable.

If a loan is acquired from a non-resident or an affected person (each as defined in the Exchange Control Regulations), the borrower is required to disclose and apply to the Financial Surveillance Department of the South African Reserve Bank (“SARB”) for approval for cross-border dealings.

In addition, if the loan is made to persons who fall within the scope of the NCA then the investor must be registered as a credit provider under the NCA. A lender who is required to be registered as a credit provider but who is not so registered, will not be able to enforce a loan agreement against a South African borrower as that loan agreement will be void in terms of the NCA.

Section 40(1) of the NCA states that “A person must apply to be registered as a credit provider if the total principal debt owed to that credit provider under all outstanding credit agreements, other than incidental credit agreements, exceeds the threshold prescribed in terms of section 42(1). Previously, the threshold of ZAR 500 000.00 excluded most casual lenders from having to register. However, on 11 May 2016, the Minister for the Department of Trade and Industry published a new determination of the threshold which has reduced the threshold to “nil R0), meaning all persons lending to persons in scope of the NCA would be required to register.

However, this applicability is limited in that the NCA does not apply to a loan agreement where the borrower is a South African juristic person and its net asset value or annual turnover of all persons related to the borrower equals or is in excess of ZAR 1 million and where the principal debt owing under the loan agreement or loan equals or exceeds ZAR 250 000 and the borrower is a juristic person whose net asset value or annual turnover is below ZAR 1 million, meaning the vast majority of corporate loans are out of scope of the NCA requirements.

Currency Considerations

The loan can be denominated in US Dollars or any other currency subject to exchange control approval, which must be obtained from the Financial Surveillance Department of the SARB in order to exchange the loan in that currency.

Collateral

A loan of this nature can be secured however, in order for the investor to benefit from receiving tax-exempt dividends as a return, security must be taken directly over the assets of the borrower. If security is taken from a third-party, then the benefit of the dividends being tax-exempt will be lost and the return will be treated as interest received for an ordinary loan and will be taxable.

Priority Payment Rights

An investment of this nature can provide for a preferential right for the investor to receive distributions based on an agreed portion of gross revenues, free cash flow or net income.

Distribution and Redemption Limitations

Unlike a distribution based on a share/equity based structure, the payment of the return as well as the redemption of the loan is not subject to any mandatory conditions. It is treated like an ordinary loan in terms of priority of ranking if the investor is a secured creditor.

Timing and frequency in payments and any mandatory conditions can be contractually agreed. Should the provisions in the loan agreement be breached, the investor is entitled to call a default and enforce against the borrower.

Legal limitations to pricing or total return

If a transaction falls within the scope of the NCA, the interest will be subject to a cap. Under common law, interest on a debt will cease to run where the total amount of arrear interest has accrued to an amount equal to the outstanding principal debt, i.e. the total amount owed at any one point cannot exceed two time the outstanding principal debt (the in duplum rule). 

The NCA provides that despite any provision of the common law or a credit agreement to the contrary, the amounts contemplated in Section 101(1)(b) to (g) of the NCA that accrue whilst the consumer is in default under the credit agreement may not, in aggregate exceed the unpaid balance of the principal debt under the credit agreement as at the time that the default occurs.

The NCA applies to all credit agreements between parties dealing at arms-length (where there is no personal interest between the parties). “Arms-length” means that the transaction should have the substantive financial characteristics of a transaction between independent parties, where each party will strive to get the utmost possible benefit from the transaction.

The NCA does not apply to a loan agreement where the borrower is a South African juristic person and its net asset value or annual turnover of all persons related to the borrower equals or is in excess of ZAR 1 million and where the principal debt owing under the loan agreement or loan equals or exceeds ZAR 250 000, and the borrower is a juristic person whose net asset value or annual turnover is below ZAR 1 million.

A juristic person is considered to be ‘related’ to another juristic person if (a) one of them has direct or indirect control over the whole or part of the business of the other; or (b) the same person has direct or indirect control over both of them.

In a Supreme Court of Appeal judgement (Asmal v Essa (38/2013) [2013] ZASCA 62 (14 May 2014), the court considered whether moneys advanced were loans and the profit share amounts upon which the parties agreed constituted ‘a use consideration’ for the said loans. In light of section 4(5)(a) of the NCA, the loan transactions constituted credit agreements. 

A credit agreement, as defined in the NCA, entails credit being granted and the imposition of a ‘fee, charge or interest’ in respect of the deferred repayment, for the use of the credit. The profit share contained in the credit agreement qualified as a ‘charge’, one of the three wide terms used in section 8(4)(f) of the NCA to describe payment for the use of money owed. The court held that the loans including the profit share construct constituted credit agreements and were subject to the provisions of the NCA and because the respondent was not registered as a credit provider, thus putting it in breach of section 40(1)(b) of the NCA. This resulted in the credit agreements being found to be unlawful and thus void in terms of section 89(2)(d). 

Status in Insolvency Proceedings

In a case of a liquidation, there are 3 types of creditors to be considered when ranking creditors:

1. Secured creditors are creditors holding security for their claims in the form of a special mortgage, landlord’s hypothec, pledge or right of retention. They rank first and are paid from the proceeds of the sale of the secured asset. All types of security (other than general notarial bonds where the mortgagee has not taken possession of the property subject to the bond) will, if validly created, constitute the holder of a security interest as a secured creditor in relation to the secured asset. No special priority applies among the secured creditors, as each secured creditor has a secured claim in respect of a particular asset. To the extent that creditors have security over the same asset, the creditor granted security earlier in time usually has a higher-ranking claim in respect of that asset. Where a secured creditor’s claim is not satisfied in full, the unpaid balance is considered a concurrent claim as dealt with in terms of (c);

2. Preferent creditors are creditors who do not hold specific security for their claims, but rank above concurrent creditors. They are paid from the proceeds of unencumbered assets in a predetermined order as set out in the Insolvency Act, 1936. Preferent creditors include employees’ remuneration (up to a prescribed amount) and the South African Revenue Services. The holder of an unperfected general notarial bond is also a preferent creditor; and

3. Concurrent creditors are paid from any proceeds of unencumbered assets that remain after preferent creditors have been paid in full. They are paid in proportion to the amounts owing to them. Any amount that remains after the payment of all concurrent claims in full must be used to satisfy the interest on concurrent claims from the date of liquidation to the date of payment, in proportion to the amount of each concurrent claim

The ranking of claims during business rescue—the regime analogous to bankruptcy in terms of South African law—is slightly different from the general liquidation process and ranking. It is also subject of some controversy, but is regarded as being as follows: 

1. fees and expenses (including legal and the other professional fees) of the practitioner incurred during business rescue proceedings; 
2. amounts due to employees which become due and payable after the commencement of business rescue; 
3. claims of secured lenders or creditors before business rescue (although this is open to some debate); 
4. secured claims by post-commencement financiers, lenders or creditors in the order in which the claims were incurred; 
5. unsecured claims by post-commencement financiers or creditors in the order in which they were incurred; 
6. remuneration of employees which became due and payable before business rescue commenced; and 
7. unsecured claims of lenders or creditors incurred prior to business rescue.

Limitation of Liability

An investor’s liability towards the company and its creditors will be limited to its funded investment. There are certain exceptions to this, an investor may be liable the most notable example of which is the extension of liability to investors in environmental law breaches.

As an example, the National Environmental Management Act 1998 and the National Water Act, 1998 extend the net of liability for pollution and environmental degradation to include, among others, persons:

1. responsible for or who have directly or indirectly contributed to pollution or environmental degradation; and/or
2. who negligently failed to prevent the activity being performed that resulted in the pollution or environmental degradation.

It would however be difficult to show that the investor would have been empowered to prevent the activity being performed that resulted in the pollution or environmental degradation.

Transfer Restrictions

It is possible to transfer the loan to another investor provided it is permitted under the terms of the loan agreement and it is not restricted. A transfer in whole would generally not be restricted unless it is contractually restricted however, a transfer in part would require consent from the borrower which consent can either be given at the time of transfer or as an exclusion in the loan agreement to allow for partial transfer.

Critical Tax Considerations

These loans would be typically structured to fall within the ambit of section 8FA of the Income Tax Act so that the returns are received by investors in the form of dividends which are tax exempt. South African investors receive a tax-exempt return. It’s not clear if this is the case for a foreign investor, as they may be liable for withholding tax. Whether or not that dividend withholding tax can be reduced is dependent on the existence and applicability of the double tax treaty between the country of the foreign investor and South Africa

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

This analysis was provided by TozziniFreire Advogados

Related Content

The analysis for Brazil includes articles on Brazil Revenue Based Finance -Debt and Brazil Revenue Based Finance – Equity

Executive Summary

This research paper summarizes the main structures identified for revenue-based financings available in Brazil. 

While Brazilian laws does not provide for concepts that are designed specifically for revenue-based financing , companies and investors may structure transactions by adjusting existing types of funding mechanisms available under existing regulations. For the purposes herein, we will suggest three types of structures, under equity, debt and receivables discount models:

Equity: investment by acquiring equity interest is one of the most common types of investment in Brazil. The acquisition of equity interest may occur by means of (i) execution of a share/quota purchase agreement, (ii) execution of a convertible loan, (iii) increasing the corporate capital by means of execution of an investment agreement, and (iv) incorporating a Brazilian subsidiary. Brazilian law provides for several types of legal entities, of which the Sociedade Limitada (limited liability company) and the Sociedade Anônima (corporation) are the most commonly used. Other company types are seldom used in practice, because most of them provide for unlimited liability of their partners. For limited liability companies and corporations, the partners liability is limited to their paid stake in the corporate capital and there are generally no minimum capital requirements. Moreover, dividends are currently tax exempt in Brazil, regardless of the status of the beneficiary. In this type of investment, it is possible to ensure a minimum return by means of (i) defining the interest in the convertible loan agreement; (ii) a put option, granted in an agreement between the partners and the company; or (iii) using redeemable shares.

Debt: issuance of debentures. A debenture is a security issued by a corporation (sociedade anônima), with mechanics that are similar to bonds governed by New York laws. The terms and conditions of the issuance of the debentures are regulated in an indenture executed by the issuing company. The debentures are essentially fixed-income debt instruments where the debenture holders are entitled to receive the repayment of the principal amount plus an accrued interest (fixed or floating). However, Brazilian laws allow the issuing company to stipulate that debenture holders may have the right to receive a share in the company’s profits or even an additional premium fee, which is based on income or profit variations of the company. The investors are usually represented by a fiduciary agent (similar in nature to a trustee). Debentures are one of the most relevant debt instruments used by companies in the Brazilian capital markets. 

Receivables discount (securitization): funding granted by receivables investment funds (Fundos de Investimento em Direitos Creditórios – “FIDC”), which is a form of condominium regulated by the Brazilian Securities Commission (Comissão de Valores Mobiliários – “CVM”). The FIDC is a fund whose main purpose is to purchase receivables from Brazilian entities, and it benefits from technical and specialized services of administration, portfolio management and custody of the investments, provided by regulated entities.  The FIDC is funded by investors, which in turn receives quotas issued by the FIDC. Although the FIDC (and investment funds in general) operate similarly to companies, it does not have a legal personality. Earnings from investments are distributed to FIDC’s quotaholders. On the other hand, the FIDC’s quotaholders also bear losses and other expenses that compose its liabilities. The FIDC is a viable way of ensuring that companies obtain cash by anticipating their receivables (revenues) without incurring in additional debt.

Members of TozziniFreire Advogados are qualified to practice law in the Federative Republic of Brazil.  We do not express herein any answer concerning any law other than the law of the Federative Republic of Brazil.

Investment Structure Summary

Transactions in Brazil usually do not provide for preferential rights to receive distributions based on an agreed portion of gross revenues, free cash flow or net income. Nonetheless, there is no explicit prohibition in this regard under Brazilian law, hence, initially, it is possible that a debt instrument provides for preferential rights regarding the company’s profits if agreed between the parties.

One common example of debt structure that may provide for this type of preferential rights in Brazil is the issuance of debentures.  Debentures are securities regulated by Law No. 6404 of December 15, 1976, which provides that corporations (sociedades anônimas) may issue debentures entitling its holders to credit rights according to the conditions set forth in the indenture. Debentures are debt instruments that may or may not be convertible into shares against the issuing company. The debentures are essentially fixed-income debt instruments where the debenture holders are entitled to receive the repayment of the principal amount plus an accrued interest (fixed or floating). However, Brazilian laws allow the issuing company to stipulate that debenture holders may have the right to receive a share in the company’s profits or even an additional premium fee, which is based on income or profit variations of the company. This permission to estipulate premium or variable coupon based on company’s income or profit variations allows Brazilian players to structure debt financing that follows a rationale that is similar to a revenue-based financing, given that the investors will have the right to receive additional payments deriving from company’s profits (as premium or variable coupon) and, generally speaking, Brazilian bankruptcy laws determine that creditors of the company have preference in payments compared to its shareholders.   

Debentures may be subject to private placements or public offerings. If public offered to investors, it must observe the rules of the CVM concerning public offerings of securities. 

Two types of ESG related debentures have been issued in the past few years, (a) green, social and sustainable bonds, and (b) sustainability-linked bonds (“SLB”).

The green, social and sustainable bonds aim to attract capital to projects that have a positive social and environmental impact. On the other hand, through SLB, companies are required to achieve agreed ESG goals and following key ESG performance indicators (KPIs).

Category

Debt or Both (debentures may or may not be convertible into shares, as agreed with investors).

Category for tax purposes

Debentures’ income is categorized for tax purposes as fixed income investment (see Critical Tax Considerations below).

Governance Rights

The debentures’ indenture may provide for clauses determining the need of prior consent of the investors for the approval of specific matters in shareholders’ meetings. This is not mandatory and commercially negotiable. Debentures used in venture debt or private equity deals tend to be more restrict in terms of what companies may or may not do in terms of governance.

Investor Qualification Requirements

Investor qualification requirements could apply depending on the public offering regime adopted, in accordance with CVM regulations. The issuance of convertible debentures from companies in the preoperational stage (A-Category) can only be acquired by professional or qualified investors. Moreover, the issuance of convertible debentures from operational companies (A-Category) in the automatic registration regime, without prior review by a self-regulatory authority, after January 2, 2023, should also only be acquired by professional and qualified investors. Common debentures (i.e., not convertible) issued following the automatic registration regime, without prior review by a self-regulatory authority, may be acquired by qualified or professional investors, and by retail investors only in certain specific situations, such as the case of standardized debentures.

For reference, qualified investors are:

1.  professional investors.
2.  individuals or legal entities that have financial investments worth over R$ 1,000,000.00 (one million reais). Statement of their status as qualified investors also needs to be provided.
3. individuals that have been approved in technical qualification exams or have certifications approved by the CVM as requirements for registration as autonomous investment agents, securities portfolio managers, securities analysts, and securities consultants, in relation to their own resources.
4. investment clubs, provided they have a portfolio managed by one or more quota holders that are qualified investors.

And professional investors are:

1. financial institutions and other institutions authorized to operate by the Central Bank of Brazil.
2. insurance companies and capitalization companies.
3.  open and closed complementary pension fund entities.
4.  individuals or legal entities that have financial investments worth more than R$ 10,000,000.00 (ten million reais). Statement of their status as professional investors also needs to be provided.
5.   investment funds.
6. autonomous investment agents, securities portfolio administrators, securities analysts, and securities consultants authorized by the CVM, in relation to their own resources.
7.   non-resident investors.

Investors of debentures may be either local or foreign. Any investment by foreign investor in debentures that are subject to public offerings and registered in organized markets must be made in accordance with Resolution No. 4,373. Resolution No. 4,373 provides that financial instruments and securities acquired by non-resident investors (including registered debentures) must be: (i) registered and deposited in an institution authorized by the Central Bank of Brazil or the CVM; or (ii) registered in a clearing and settlement system authorized by the Central Bank of Brazil or the CVM to render this service.

Before making the investment, the non-resident investor must (i) appoint a legal representative in Brazil, which must be a financial institution authorized by the CVM or the Central Bank of Brazil; (ii) obtain a registration as a foreign investor with the CVM; and (iii) appoint a custodian of securities authorized by the CVM (which may be the same entity as the legal representative).

Additionally, the assets owned by the foreign investor (i.e., the registered debentures) must be deposited in the non-resident investor’s account or in a collective account in a financial institution authorized by the CVM or Central Bank of Brazil to provide these services. The foreign investor must also be registered at a local brokerage firm.

Currency Considerations

The debentures must be denominated in Brazilian reais, except in case of obligations in which Brazilian laws authorizes payments in foreign currencies. Exceptions include situations of foreign investors. Accordingly, debentures issued abroad may be denominated in foreign currency.

For local debentures, Brazilian law authorized the issuance in Brazilian reais and indexed to foreign currencies.

Collateral

Security interest and guarantees may be granted by the issuer if required by investors. The following types are usually requested in the financial and capital markets, cumulatively or alternatively:

• Fiduciary transfers;
• Pledges;
• Mortgages; and
• Personal guarantees.

In a fiduciary transfer structure, a certain asset is transferred to the debenture holders on a fiduciary basis and by way of security to ensure payment of a given obligation. Upon fulfillment of the secured obligation, the debtor reacquires full title to the asset, thereby extinguishing the fiduciary ownership held until then by the debenture holders. In the event of default by the debtor, however, the debenture holders obtain full title to the asset, which must then be sold to satisfy the unpaid debt.

In the pledge structure, if the debtor fails to pay the relevant obligation, the creditor will have the right to sell the pledged asset through a judicial sale or through a private sale, if authorized by the pledge agreement or by a special power of attorney granted by the pledgee. The proceeds will be applied to the unpaid debt. As a matter of Brazilian law, pledge agreements cannot provide that creditors are entitled to keep pledged assets if debtors fail to pay. However, in case of credit rights the creditor will use the relevant amounts to be reimbursed on the value of its credit. Structures involving liens over bank accounts where the credit rights are deposited are common in Brazil.

A mortgage is a security interest created over real estate or other certain asset specified by law. Under a mortgage structure, if the debtor fails to pay the relevant obligation, the creditor will have the right to sell the mortgaged asset through a judicial sale and use the proceeds to satisfy the unpaid debt. As a matter of Brazilian law, mortgage agreements cannot provide that creditors are entitled to keep mortgaged assets if debtors fail to pay.

A security interest may be created over a variety of assets: real estate, fungible movable assets, non-fungible movable assets, rights and credit rights. Depending on the asset to which the security refers, the agreement must be registered with either a Real Estate Registry Office, a Registry of Deeds and Documents or another type of registry (such as corporate books in case of shares).

Priority Payment Rights

Preferential rights are not necessarily linked to equity rights, but to an obligation of the company to pay to investors a certain premium or variable coupons of the debentures based on financial factors of the company. Under local bankruptcy laws, the investors of the debentures will have priority of payments compared to existing shareholders.

For example, it is possible to establish that the issuing company will have to pay an additional premium to investors calculated over a percentage of payments received from certain commercial contracts executed with clients (i.e., if those receivables are not paid, then the company will not have an obligation to pay the premium). Another example is to provide in the indenture that the company will have to pay a variable coupon calculated over an agreed formula that takes into consideration certain its financial conditions (for example: monthly income x EBITDA x fixed percentage). 

Distribution and Redemption Limitations

The indenture may provide for negative covenants in which the issuer is not allowed to distribute dividends and profits to its shareholders above the minimum legal amount, without prior consent of the investors. 

Legal limitations to pricing or total return

Decree No. 22.626/1933 (Usury Law), prohibits and establishes penalties if there is stipulation in any contracts of interest rates higher than twice the legal rate. Thus, the Usury Law functions as an interest control mechanism for loans offered to the private productive sector. It is also worth mentioning that usurious stipulations that establish interest rates higher than legally permitted in civil loan contracts are null and void, in which case the judge must, if requested, adjust them to the legal measure or, if they have already been complied with, order the refund in double of the amount overpaid, with legal interest from the date of the undue payment, as provided by Provisional Measure No. 2,172-32, dated August 23, 2001.

It is worth noting that the Brazilian Superior Court of Justice (“STJ”) has a settled understanding that financial institutions are governed by a specific law and, therefore, the above-mentioned interest limitation does not apply to them. In addition, in a decision by STJ (SPECIAL APPEAL No. 1.634.958 – SP (2016/0277295-7)) on the applicability of the legal rate limits to investment funds, the STJ held that investment funds have similar roles as financial institutions, given that their activities involve attracting popular savings through the issue and subscription of securities for the granting of credit, and therefore they also do not need to observe usury rules.

Thus, for the reasons given by the STJ, our understanding is that the legal rate limit is not applicable to financial and capital markets transactions. However, interest limitations may apply to debentures and other securities subject to private placements that do not involve financial institutions and that are not registered in organized markets and, therefore, follow the same rationale as loan transactions (as opposed to debentures subject to public offerings, which are considered investments in the capital markets).

For reference, although there are certain discussions about what is the “legal rate” for the purposes of interest limitation, our understanding is that interest should be limited to the Special System for Settlement and Custody (“SELIC”) rate. Any interest due above the SELIC rate may be considered by Brazilian courts null.

Status in Insolvency Proceedings

Status in insolvency proceedings will depend on whether the credit rights are collateralized. The debentures may also be subordinated, which means that the credit of the debenture holder would have preference only over the shareholders of the issuer, in the event of bankruptcy.

Brazilian insolvency law provides for the following priority of payment in bankruptcy scenario of a debtor: (i) claims arising from labor legislation, limited to one hundred and fifty (150) minimum wages per creditor, and without limit for those resulting from an occupational accident; (ii) credits encumbered with security interest up to the limit of the value of the burdened asset; (iii) tax claims, regardless of their nature and the time when tax event occurred (an exception to non-concurrent claims and tax fines); (iv) unsecured claims; (v) contractual fines and pecuniary penalties for breach of criminal or administrative law, including tax fines; (vi) subordinated credits; (vii) interest accrued after the decree of bankruptcy.

Furthermore, bankruptcy and judicial reorganization proceedings bind all the existing credits against the relevant debtor at the time of the request (pre-petition claims), even those undetermined or not yet matured or disputed, contingent, or unsettled at the time of the filing except for (i) tax and social security-related credits; (ii) credits related to forward foreign exchange agreements; and (iii) claims (a) arising from financial leases, (b) secured by a fiduciary lien (“alienação fiduciária”), (c) of owners or committed sellers of real estate which respective agreements include an irrevocable and or irreversible provision, and (d) purchase agreements containing a title retention provision.

Limitation of Liability

Investors’ liability towards the issuer is limited to its funded or committed investment.

Transfer Restrictions

The debentures may be subject to transfer restrictions of up to eighteen (18) months depending on the public offerings regime, the situation of the company (if operational or preoperational) and the types of investors involved

Critical Tax Considerations

Debentures’ interest is taxed as follows:

• Foreign investor duly registered with the Brazilian Central Bank as portfolio investor (Resolution 4.373) and not located in a tax haven: 15% withholding tax;
• Foreign investor not registered with the Brazilian Central Bank as portfolio investor (Resolution 4.373) and located in a tax haven: 25% withholding tax; 
• Local investor – Individual: 15% to 22.5% regressive withholding tax rates (according to the maturity of the investment); 
• Local investor – Legal entity: same rates described above, but the final tax cost will vary according to the legal entity’s tax regime.

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

This analysis was provided by Hogan Lovells

Related Content

The Analysis for The Netherlands includes articles on Revenue Based Finance – Debt, and Revenue Based Finance – Preference Shares

Executive Summary

Although it is important to note that the current legal landscape in the Netherlands lacks distinct provisions for revenue-based financing – as there are no codified revenue-based financing structures – we have identified two ways in which such financing can be structured using existing Dutch law concepts:

1. through issuance of equity like instrument in the form of preference shares (preferente aandelen); and 
2. through the issuance of debt like instrument in the form of loans (leningen). 

In the schedules below, the focus is only on private companies with limited liability (besloten vennootschap met beperkte aansprakelijkheid), incorporated under the laws of the Netherlands and having their corporate seat (statutaire zetel) in The Netherlands. A private limited liability company is the most customary legal form in The Netherlands. 

Loans (leningen): Revenue-based financing in The Netherlands can be structured as a loan repaid based on a percentage of monthly revenues (on a contractual basis). This option aligns the investor’s interests with the company’s performance, as returns are directly linked to the company’s growth. Dutch law provides flexibility in creating board observer roles and allows for collateral-backed loans to have priority in insolvency proceedings. Lenders operating in The Netherlands should ensure compliance with regulatory constraints and licensing requirements. Given the freedom of contract under Dutch law, revenue-based financing through a loan structure may be an ideal solution for revenue-based financing. 

This memorandum is provided for general informational purposes only and should not be considered as legal advice or a substitute for professional advice tailored to any specific situation. The structuring of any financing arrangement always depends on the particular facts and circumstances, and it is essential to consult with legal counsels before taking any actions or making decisions based on this information. This summary does not purport to be complete or cover all aspects of the subject matter and should not be relied upon as a basis for any decision or action that may affect your interests.

 

Investment Structure Summary

The provision of a loan which is repaid based on a percentage of the monthly revenue would be an option for revenue-based financing under Dutch law given the freedom of contract

This is structured as a loan and repaid through monthly payments based on a percentage of revenues. These monthly payments continue until a repayment threshold has been reached. The loan can be paid off sooner, if the company grows in fast pace. The returns for the loan provider are directly linked to the company’s performance, in contrast with preference shares. The investor’s interest therefore is in harmony with the company’s interest. In this scenario, the amount owed by the company will be treated as a liability.

Category

According to Dutch law, a loan is classified as debt. However, its classification may vary when viewed from the standpoint of accounting and tax regulations.

Category for tax purposes

Please refer to Critical Tax Considerations below.

Governance Rights

In general, debt instrument holders do not have corporate and voting rights with respect to the company and its management. Nevertheless, exceptions can occur during enforcement, like when a lender acquires voting rights by transferring them based on a share pledge. 

However, due to the considerable flexibility provided by Dutch company law and the lack of definitive case law or scholarly doctrine, it is also possible to establish, for instance, board observer roles by contract.

Investor Qualification Requirements

Lenders operating in The Netherlands must navigate various regulatory constraints and may require a license under the Dutch Financial Supervision Act (Wft) to lend legally. As per the Capital Requirements Directive, EU member states, including The Netherlands, have discretion over lending activities by non-bank entities. In The Netherlands, a license is generally not needed for financing that excludes regulated mortgages or consumer credit, while deposit-taking faces certain restrictions. Ensuring compliance with these regulations is essential to avoid complications or penalties.

Currency Considerations

There is no specific restriction under Dutch law in terms of the currency for the payment obligations. 

Collateral

Security interests and guarantees can be granted in connection with financing in the Netherlands, where security is typically provided as in rem security (zakelijk zekerheidrecht). A right of pledge (pandrecht) can be granted for tangible assets and receivables. For tangible assets, a pledge may be possessory or non-possessory, while for receivables, it can be disclosed (i.e. by serving a notice on the debtor) or undisclosed. A right of mortgage (hypotheekrecht) serves as a security interest for real estate and related rights

Priority Payment Rights

Under Dutch law, there are no statutory preferences for financing arrangements that grant parties the right to receive distributions according to agreed percentages of gross revenues, free cash flow, or net income. However, the ranking during insolvency in the Netherlands is determined by whether or not the loan is secured.

For more information regarding priority payment rights, please refer to Status in Insolvency Proceedings below.

Distribution and Redemption Limitations

There are no statutory limitations or restrictions on the repayment of debt instruments; however, the loan documentation may include negative contractual covenants that prohibit the borrower from distributing dividends and profits to its shareholders.

Please refer to Investment Structure Summary for the distribution of payments to lenders. 

Legal limitations to pricing or total return

Under Dutch law, usury is not regulated other than in relation to consumer credit loans. There are no laws or restrictions that limit interest amounts, as long as the credit provided does not pertain to consumers. However, in exceptional cases, a contractual clause stipulating excessive interest may be invalidated based on principles of reasonableness and fairness or good morals. 

Status in Insolvency Proceedings

In Dutch insolvency law, two standard proceedings exist: bankruptcy (faillissement) and suspension of payments (surseance van betaling). Secured creditors are generally unaffected by bankruptcy, and their claims are paid from the enforcement proceeds of the security right.  Secured creditors have a strong position and can enforce their rights as if no insolvency is occurring.

Payment priority in Dutch bankruptcy scenarios, subject to exceptions, follows a specific order: general costs, secured creditors, specific and general privileged creditors, unsecured creditors, subordinated creditors, and shareholders.

Limitation of Liability

Lenders’ liability is limited to disbursing committed funds on the basis of contractual obligations. They are generally not liable vis-à-vis third parties for actions or omissions of the company

Transfer Restrictions

In accordance with Dutch law, the assignability of a loan is subject to the nature of the underlying agreement. A highly personal nature of the claim is one factor that may render it non-transferable. Furthermore, the transferability of claims may be limited by the agreement between debtor and creditor, as well as by the nature of the claim.

Critical Tax Considerations

Dutch borrowers are subject to Dutch corporate income tax at the prevailing statutory rates. Generally, no withholding tax is imposed on arm’s-length interest payments, principal repayments, or related fees in the Netherlands. Consequently, borrowers are not accountable for withholding tax and do not need to indemnify lenders for such taxes, as interest charges are tax-deductible.

It is advisable to seek tax advice in each specific case. While the Netherlands typically does not impose withholding tax on arm’s-length interest payments, principal repayments, or related fees, exceptions exist (for example in certain (tax abuse) situations), and these should be assessed on an individual basis.

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

This analysis was provided by Hogan Lovells

Related Content

The Analysis for The Netherlands includes articles on Revenue Based Finance – Debt, and Revenue Based Finance – Preference Shares

Executive Summary

This memorandum summarises and provides a general overview of the main structures identified for revenue-based financing available in The Netherlands. Revenue-based financing entails a finance arrangement in which the investor is entitled to a preference in the receipt of payments out of the enterprise’s revenues, either as return on capital or debt repayments. With the rising popularity of revenue-based financing across Europe, this approach has also found its way to The Netherlands. 

Although it is important to note that the current legal landscape in the Netherlands lacks distinct provisions for revenue-based financing – as there are no codified revenue-based financing structures – we have identified two ways in which such financing can be structured using existing Dutch law concepts:

1. through issuance of equity like instrument in the form of preference shares (preferente aandelen); and 
2. through the issuance of debt like instrument in the form of loans (leningen). 

In the schedules below, the focus is only on private companies with limited liability (besloten vennootschap met beperkte aansprakelijkheid), incorporated under the laws of the Netherlands and having their corporate seat (statutaire zetel) in The Netherlands. A private limited liability company is the most customary legal form in The Netherlands. 

Preference shares (preferente aandelen): Preference shares serve as an effective instrument for raising funds in various financial structures. In practice, several types of preference shares are distinguished, each with unique characteristics. When sufficient profits or reserves are available, preference shareholders are, in principle, entitled to distributions and can request payment. Consequently, this type of financing might only suitable be when a company generates sufficient profit, and may therefore be a better fit for companies that are profitable and able to support the repayment cap. This memorandum focuses on ordinary preference shares and cumulative preference shares, exploring their differences and unique characteristics within financial structures.

This memorandum is provided for general informational purposes only and should not be considered as legal advice or a substitute for professional advice tailored to any specific situation. The structuring of any financing arrangement always depends on the particular facts and circumstances, and it is essential to consult with legal counsels before taking any actions or making decisions based on this information. This summary does not purport to be complete or cover all aspects of the subject matter and should not be relied upon as a basis for any decision or action that may affect your interests.

Investment Structure Summary

Under Dutch law, preference shares serve as a funding mechanism, providing holders with special rights such as enforceable entitlement to a portion of profits before ordinary shareholders, including dividend rights and liquidation proceeds. 

Preference shares may feature fixed ‘return’ rates, posing both advantages and disadvantages for holders. While special rights are advantageous, fixed rates prevent holders from benefiting from increased company profits, meaning they will not receive extra dividends during a prosperous year despite having greater transparency on returns.

Furthermore, non-voting preference shares can be issued without diluting existing shareholders’ voting rights or negatively affecting the equity-to-debt ratio. Classified as equity, non-voting preference shares often play a role in bank financing documentation and can be used to enable leverage (gearing). It is crucial to note that preference shareholders are in principle not considered creditors.

Category

Preference shares, when legally issued, are considered equity under Dutch law as they form part of the issued capital. However, their qualification may differ from accounting and tax perspectives

Category for tax purposes

Payment of dividends on preference shares will in general be subject to taxes and withholding in accordance with applicable laws and regulations. In The Netherlands, dividend is subject to a 15% dividend tax. This percentage can be reduced based on Dutch law, treaties, and EU law. 

For further details, please refer to Critical Tax Considerations below.

Governance Rights

Depending on the specific facts and circumstances, preference shares can economically resemble subordinated debt instruments, particularly if they offer only a fixed or variable rate of return without further entitlement to distributable dividends. 

All preference shareholders have a statutory right to attend general meetings that cannot be contractually waived. The ‘right to attend meetings’ grants them the ability to speak at any general meeting, which is distinct from ‘the right to vote’, which entitles them to vote on any matter at the general meeting. If voting shareholders wish to make a decision outside of a meeting, they require the consent of all those entitled to attend meetings, including holders of non-voting (preference) shares. This ensures that non-voting shareholders are not unexpectedly confronted with decisions they have not had the opportunity to discuss during the general meeting.

If preference shares are issued without voting rights, the holder does not have any voting rights concerning the general meeting, unless (1) a decision is made to liquidate the company, or (2) a change in the rights of the shareholders or preference holders is proposed, which in turn requires the consent of the non-voting preference shareholders. Further, holders of non-voting shares may also request the convocation of the general meeting and have the right to place items on the agenda of the general meeting. 

Investor Qualification Requirements

In general, there are no specific qualification requirements for non-regulated entities from a Dutch corporate law perspective, other than the registration in the register of shareholders and notarial requirements. Particular tax considerations may apply based on the nationality and tax status of the shareholder which may be beyond the scope of this memorandum. For further details, please refer to Critical Tax Considerations below.

Currency Considerations

Dutch corporate law offers flexibility regarding payment in foreign currencies. Under Dutch law payment for shares in a currency other than the one in which the nominal amount is denominated is only permitted before or at the time of incorporation if the deed of incorporation explicitly allows such payment. Following incorporation, this can only be carried out with the company’s consent, unless the articles of association indicate otherwise.

Collateral

Typically not relevant as preference shares are classified as equity-like instruments.

Priority Payment Rights

It is possible to issue preference shares with priority in (i) the distribution of dividends and reserves of the company and/or (ii) priority in case of liquidation of the company. For more information regarding priority payment rights, please refer to Status in Insolvency Proceedings below.

When sufficient profits or reserves are available, preference shareholders are, in principle, entitled to distributions and can request payment. The actual amount may vary, provided it can be paid based on the company’s profit. For more information regarding the payment of dividends, please refer to Distribution and Redemption Limitations below.

Distribution and Redemption Limitations

Distribution

Under Dutch law, the general meeting of shareholders decides on profit appropriation and distribution, which is permissible only if the company’s equity exceeds legal or statutory reserves. A limited balance sheet test is conducted by the general meeting before passing a resolution. The board of the company is ultimately responsible for approving that resolution for dividend distribution. Such approval will be withheld if the board either knows or reasonably anticipates that the distribution would compromise the company’s ability to meet its payment obligations, including future debts after distribution of dividend.

Typically, dividend payments are derived from the most recently approved annual financial statements, which may not be well-aligned with a monthly financing structure based on revenues. Dividends are generally calculated against profit, and the annual profit distribution usually corresponds to the profits of a specific financial year, as detailed in the financial statements. However, it’s possible to distribute interim dividends, which could be more in line with a revenue-based financing model. When the company has adequate profits or reserves, preference shareholders are entitled to request distributions. The amount of these distributions may vary, provided they can be justified based on the company’s profits. Once dividend payments are approved, preference shareholders are commonly entitled to a predefined percentage of the profit. After this entitlement is met, any remaining profit generally does not benefit the preference shareholders.

Redemption

Under Dutch law, a legal framework exists for the redemption of shares in Dutch private companies with limited liability. The redemption price is generally based on the nominal value of the shares but can be set at a pre-determined price, such as a multiple of the initial investment. However, this is always subject to the approval of both the shareholders and the board, based on a balance sheet test (as described above), and only applies if this provision was reflected in the company’s articles of association when the preference shares were issued. In other cases the approval of the affected shareholder is required for share redemption. While the redemption of preference shares can be legally and commercially structured in various ways, such terms would typically be articulated in the company’s articles of association and the preference share subscription agreement.

Legal limitations to pricing or total return

The rate of return for investors is limited to the fixed and agreed-upon dividend rate. Actual payment may be restricted, please refer to Distribution and Redemption Limitations above.

Under Dutch law, no usury laws or restrictions limit interest amounts as usury is not regulated other than in relation to consumer credit loans. However, in exceptional cases, a contractual clause stipulating excessive interest may be invalidated based on principles of reasonableness and fairness. 

Status in Insolvency Proceedings

According to Dutch law, shareholders have a lower priority in the event of insolvency, making insolvency proceedings disadvantageous for them. However, in case of insolvency, preference shareholders have a preferential position and can assert their claims before ordinary shareholders.

Limitation of Liability

Under Dutch law, shareholders are in principle not personally liable for the company’s actions and not required to contribute to its losses beyond the amount due on their shares, unless specified otherwise in the articles of association. This protects the shareholder’s personal assets from being used to pay the company’s debts in case of insolvency, except in exceptional cases beyond the scope of this memorandum.

Transfer Restrictions

Unless the articles of association provide otherwise, a shareholder who intends to sell one or more shares must first offer them to the other shareholders in proportion to the number of shares they hold at the time of the offer in order for the transfer of shares to be valid. 

Critical Tax Considerations

Any payments made to the investors would be subject to the corresponding withholding and payment of applicable income taxes at the corporate level.

The classification of instruments as equity or debt is of great importance from a tax law perspective, as they are taxed differently. The compensation on equity (dividend) is generally not deductible for the paying entity. Dividends are generally taxable for the receiving entity, unless the receiving entity can apply the participation exemption (deelnemingsvrijstelling). It is advisable to seek specialist tax advice in each specific case.